Reducing Foreign Exchange Settlement Risk

One way in which foreign exchange settlement exposures can be reduced is by netting foreign exchange obligations so that only the smaller net amounts are settled. Only 47 per cent of the surveyed banks indicated that they engage in bilateral netting agreements with their counterparts. This is quite low compared to the G10⁹ and surveyed Australian banks of 77 per cent and 62 per cent, respectively. Bilateral netting reduced the settlement flows by 8 per cent, relatively lower than that found for G10 countries in the CPSS survey in 1997, which indicated a reduction of settlement flows by 15 per cent through bilateral netting.

Table 6 provides more information on the extent of bilateral netting between participants in the Singapore foreign exchange market.

9 G10 countries conducted a second FX settlement risk survey in 1997.

Table 6: Number of Counterparties for Bilateral Netting Distribution of Number of Counterparties

Percentage of banks with bilateral netting arrangements

No. of counterparties for which have bilateral netting

arrangements Singapore CPSS 1997 Survey

0 counterparty 56 23

1-20 counterparties 26 34

21-100 counterparties 18 23

Over 100 counterparties 3 19

4.2.2 Improved Cancellation and Reconciliation Times

Besides reducing the size of settlement exposures through netting, a foreign exchange trading institution can also change its internal procedures and processes so as to reduce the duration of its settlement exposure. Specifically, it may do so by eliminating overly restrictive unilateral payment cancellation deadlines and reducing the time it takes to identify its final and failed receipts of purchased currencies.

In the survey, 38 per cent of the respondents indicated their intention to shorten the duration of their exposures. Recognising the importance of appropriate unilateral cancellation deadlines and reconciliation timings, some respondents indicated their intention to review and negotiate with nostro agents on a regular basis, while others choose to enhance reconciliation procedures to shorten the period of uncertainty.

4.2.3 Real-Time Gross Settlement

Internationally, there is a noticeable trend towards the establishment of RTGS systems for settlement of high-value payments, such as foreign exchange transactions. Our survey shows that over 96 per cent of foreign exchange flows on the books of banks can now be settled on a real-time gross settlement basis. This provides banks with the opportunity to reconcile final receipts earlier during the operating

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hours of the RTGS system instead of having to wait until the end of the netting cycle. However, this is only possible if the correspondent banks identify receipts and despatch statements promptly. The surveyed banks tend to delay the reconciliation of Asia-Pacific currencies to the following day after value date, thereby prolonging their exposures unnecessarily.

4.2.4 Continuous Linked Settlement (CLS)

The concept of CLS arose in 1995 as a result of the G-20’s study on foreign exchange settlement risk.¹⁰ Essentially, CLS is a private sector initiative to simultaneously settle both sides of a foreign exchange transaction across the books of CLS Bank. CLS will contribute towards eliminating settlement risk which can occur when each leg of a foreign exchange transaction is settled separately. CLS Bank is expected to commence operations in October 2001. CLS Bank will initially provide simultaneous settlement capabilities for seven major currencies, i.e.

AUD, CAD, EUR, JPY, GBP, CHF, USD and more currencies will be included at a later stage.

The CLS Bank will be supervised by the Federal Reserve Bank of New York. However, its settlement processing will be done in UK.

Currently, there are over 60 shareholders banks in the holding company for CLS Bank, CLS Services (CLSS). These shareholders will be eligible to participate in CLS Bank directly. All other entities, which are not shareholders of CLSS, may access CLS services as third party customers.

Of the 38 per cent of respondents who indicated intentions of shortening their exposures, approximately 17 per cent highlighted

10 The G20 is an ad-hoc committee of major foreign exchange trading banks.

participation in CLS as a measure to reduce their foreign exchange settlement risk.

4.2.5 Payment versus Payment¹¹ (PvP)

Besides CLS, another possible option to reduce foreign exchange settlement risk might be the establishment of bilateral or multilateral cross-border links between national RTGS payment systems. In particular, direct operational and informational links could be created that would give participating central banks the joint capability to monitor, control and simultaneously execute final transfers over their respective home-currency payments systems. With such cross-border connections, central banks could directly provide the private sector with PvP settlement services for currencies with overlapping payments system operating hours. However, in the CPSS report, Central Bank Payment and Settlement Services with respect to Cross-Border and Multi-Currency Transactions, private sector effort was the preferred approach to reduce risk and increase efficiency in the settlement process.

4.2.6 Longer Payment System Operating Hours

The extension of the operating hours of an individual payment system would help to reduce the current gap (or increase the current overlap) with the operating hours of other countries' payment systems.

Combined with the availability of final transfers over those systems, such an overlap could allow all relevant currencies to settle on a PvP basis, thereby assuring counterparties that payments in one currency would be made if and only if payments in all relevant currencies are made.

11 Payment versus payment is a mechanism in a foreign exchange settlement system which ensures that a final transfer of one currency occurs if and only if a final transfer of the other currency or currencies takes place.

4.2.7 Contracts for Difference (CFD)

A CFD is an agreement between two counterparties to replace a traditional foreign exchange transaction with an obligation to make (or the right to receive) a single payment, in a predetermined currency, representing the market gain or loss that would have resulted from the forgone foreign exchange transaction. This instrument could deliver benefits analogous to those of bilateral netting. This initiative is based on the premise that a large portion of foreign exchange transactions are for hedging or speculative activities which only require settlement of the mark-to-market profit or loss.